Tough times ahead for economy, but no one's using the 'R' word yet

The internet didn't exist the last time Australia slid into recession.

Margaret Thatcher was in power in Britain. The Berlin Wall had fallen, but there was no European Union.

Storm clouds are accumulating on the economic horizon.Credit:Nick Moir

At home, a young Tony Abbott had just ditched his job writing editorials for The Australian newspaper to become press secretary to Opposition leader John Hewson. A year out from university, Bill Shorten was yet to join the payroll of the ACTU.

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In short, it was a long time ago – a quarter of a century, to be exact.

Warwick McKibbin: The chance of recession in the next 12 months is line ball.Credit:Michel O'Sullivan

Anyone aged under 40 in Australia today has never experienced a recession in their working lifetime.

National accounts released this week revealed Australia has just racked up an astonishing 96 quarters of consecutive growth, second only to Netherlands' winning streak of 103 quarters.

But our record-breaking run is in peril. The Australian economy has hit the skids. Tumbling commodity prices have dealt the national economy a supersized pay cut.

Growth in economic output slowed to a crawl of just 0.2 per cent in the three months ended June.

Economist Saul Eslake likened the tax system to a "giant Swiss cheese".Credit:Arsineh Houspian

According to former Reserve Bank board member Warwick McKibbin, Australia now faces a 50 per cent chance of falling into recession in the coming year.

Resource-rich states are on the rocks, leaving New South Wales and Victoria and their heavily service-based economies to take back the reins of growth.

For the Abbott government, which celebrates two years in power next Monday, its record on economic management – a traditional strength for Coalition governments – is increasingly under the microscope.

Since the 2013 election, joblessness has risen, real wages growth has evaporated and government debt has ballooned.

Since the 2013 election, joblessness has risen, real wages growth has evaporated and government debt has ballooned.

Budget forecasts assuming a return to historic rates of growth are "highly unlikely" to prove correct, according to independent economist Saul Eslake, meaning surpluses are some way off.

The confidence boost that the election of a Coalition government was supposed to produce has failed to materialise, says Eslake.

Worse, the relentless focus on national security issues has actually undermined confidence, with real economic consequences: "I think it has taken an economic toll," he says. "The Coalition keeps telling people that you ought to be scared. We need to be scared about border security, food security, water security. We keep telling people there's bad stuff out there and no wonder they become risk averse."

BUT no one is allowed to use the "R" word yet.

According to convention, a technical recession is said to occur when an economy racks up two consecutive quarters of "negative growth", that is, two consecutive three-month periods in which economic output is smaller than the previous quarter.

Some point out that Australia is already in an "income recession", with disposable income per person shrinking for more than a year thanks to falling commodity exports. But while prices are falling, the quantity of economic output continues to grow, according to the latest figures.

Still – recessions can creep up on you, according to the chief economist at Laminar Capital, Stephen Roberts.

"Often you don't know until it's too late. By the time you get those two sets of GDP numbers with negative growth, you can be a far way down the track to recession. It was the issue last time around. It took a long time for people to realise we were in recession. It was the same in the early 1980s as well."

Roberts puts the chances of a recession in the next 12 months at between 35 and 40 per cent, up from 25 per cent before he saw Wednesday's national accounts.

Such meagre growth could easily turn into no growth at all. And the warning signs are there, says Roberts.

Not only is China's growth slowing, it is becoming less resource hungry as the drivers of growth shift from construction to domestic consumption.

Australian home values – a key support for household spending – are also "highly exposed" to any reverse in the tide of incoming foreign investment, warns Roberts.

"Normally we don't think there's a problem with the housing market until the unemployment rate goes up. In this particular housing cycle, there has been been a significant contribution from overseas investors. There is an increasing risk that tighter and tighter capital outflow controls will be imposed [as Asian countries seek to prop up their currencies]."

Meanwhile, weaker wages growth and falling national income will keep households on the sideline.

McKibbin, an economics professor at the Australian National University who sat on the board of the Reserve Bank between 2001 and 2011, estimates there is a 50 per cent chance Australia will fall into recession in the coming 12 months.

"If you did absolutely nothing from now on … there is probably about 50 per cent probability over the next 12 months."

McKibbin says resource-rich Canada, which slipped into technical recession this week, is a "good leading indicator".

"The problem we have is we have got weak exports. We have got high volatility in financial markets – that weighs on confidence. Then we have got a political stalemate at the same time the government is looking at getting significant reform in place."

McKibbin says Labor's opposition to the free trade agreement with China and the government's abandonment of the East West Link project in Melbourne are all risks to growth.

"All those bits and pieces add up to slower economic growth. There aren't too many bright spots out there," he says.

A lower Aussie dollar – which slipped below US70 cents this week – will help buffer the economy. But McKibbin warns that the Reserve Bank has "already used up their ammunition".

"We should be cutting rates now from a higher starting point," he says. "When you cut interest rates it just brings demand from the future to the present. Now we're at the point where we have already taken that demand away. How do you fill the gap now? That's the dilemma."

Eslake puts the risk of a recession still at 25 per cent – no higher than he thought two years ago.

"I don't think anything we have learned about the June quarter should lead people to become more pessimistic for the chances of recession than they were. We're stuck in second gear and have been for a long time."

Eslake says we are seeing a "rotation" in the sources of growth away from capital-intense activities like mining and towards more labour-intense industries like housing construction, tourism and household services. Thats why incomes have fallen, but jobs growth has held up.

Overall, "Growth will be below what we have come to regard as trend," says Eslake.

"This is not the GFC. It's not the Asian Financial Crisis. It's probably more like the tech wreck of 2000. This is an equity market event and it's painful for equity investors but there are no signs of stress in credit markets."

However, Australia is more vulnerable to a shock than it was going into the GFC, warns Eslake. "The economy lacks the momentum to absorb and we have far less policy ammunition."

So, are we sleep walking into "a real mess", as former Treasury secretary Martin Parkinson warned at this month's National Reform Summit?

Not necessarily, says McKibbin.

"We don't have to go through recession because it really comes down to confidence and what consumers and businesses in the economy are doing."

But confidence is sorely lacking.

As for the Abbott government's economic record, McKibbin says: "I would say that its policies that have been delivered haven't been adequate to the problems we face."

Yes, the government has faced a belligerent Senate and Opposition, but "they should have pushed on to the point of double dissolution", says McKibbin.

It is not too late to announce confidence-enhancing reforms, he says.

"If you do it in a credible way, that increases people's confidence."

Major infrastructure projects not only boost economic activity, but lift the economy's future speed limit, says McKibbin. He also advocates a shift from income to consumption taxes and broadening the GST base, along with labour market reform.

Laminar's Roberts also makes the economic case for spending on infrastructure.

"It is a matter of choice whether we have this slow growth rate or not," he says. "There's a lot that can be done, like, can we get some sensible discussion about what's good borrowing?"

Higher migration would also boost the economy.

Roberts says it's too soon to slate the blame home to the current government. However, the failure of politics to drive reform is putting more pressure on other policy tools, like interest rates, he says. "The RBA feels it's under enormous pressure to use a policy tool that's not overly matched to this situation.

"At least we have got a currency that floats and can go down."

Eslake, a former chief economist at Merrill Lynch Australia and ANZ, is more critical of the Abbott government's economic record.

"There is an ongoing inability of this government to develop a confidence-enhancing narrative."

"Apart from undoing things that the previous government did that they thought were wrong, what else have they done? They haven't got debt under control. Debt is bigger than it was when they came into office. They have dissipated a lot of political capital. There's not any clear momentum for reform in a second term of government that you might have hoped for. Confidence has dissipated."

Eslake is also scathing of Labor's Opposition to the Chinese free trade agreement which, along with agreements with Japan and Korea, he nominates as the Abbott government's greatest economic accomplishment.

"No, you can't blame the Abbott government entirely. Part of Australia's problems are down to the fall in the terms of trade and that's not the Coalition's fault.

"But when I talked to investors in my former role they really had a naive faith that the mere fact of getting rid of a government that people clearly despised and insertion of a conservative government would have a tangible economic effect. That just simply hasn't happened."

Budget assumptions of growth of 3.5 per cent in coming years are unrealistic, says Eslake.

"The budget projections are a bit like my hopes for Tasmania getting its own team in the AFL. It's highly unlikely."

History suggests there are tougher times ahead.

Roberts says: "I think you have to go through very difficult economic times … The 1974-75 recession was severe and the 1982-83 recession was crippling. In some senses it was that background of very difficult economic conditions and the need to change that drove the political will to change."

And while it may be easy to blame politicians, all Australians may share some of the blame for any coming recession, says Roberts.

"Basically, political will comes from the people. We blame the politicians, but the politicians are in some ways a reflection of ourselves and we just don't want to wear the pain of reform."